Bank of Canada criticized for inflation targeting

by Paul Lucas02 Feb 2016

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Bank of Canada criticized for inflation targeting

The Bank of Canada has been criticised by two highly regarded economics professors for what they describe as a “narrow focus” towards inflation and a “hands-off approach” with regards to movements of the exchange rate.

Speaking to The Globe and Mail, Paul Beaudry and Amartya Lahiri, who are both professors within the Vancouver School of Economics, at the University of British Columbia, highlighted how the Canadian dollar has suffered a precipitous level of depreciation over the last year. They commented on how the Bank of Canada, as a bank that targets inflation, has responded to this change by focusing on setting policy with the aim of attaining its two per cent target. However, they do not believe this is Canada’s best option.

In their column, they highlight how an inflation targeting policy was introduced at the beginning of the 1990s and how it has been successful in stabilising the country’s inflation rate: for which it deserves a great deal of credit. However, simultaneously, with inflation targeting, there is no targeting of the exchange rate – and instead, this is determined by market force alone.

This, they believe, is a mistake: leaving the market to know that the dollar will fluctuate with commodity prices – even though they previously had little in the way of predictive power. Now however, it seems that the Canadian dollar is fluctuating too closely to commodity prices.

With this outcome they believe there are two possibilities. The first would be to stablise commodity prices in Canadian dollars – therefore helping to stablise the oil sector too. However, this relies on the dollar fluctuating greatly with international commodity prices and the prices of other imports and exports must also show great movements. The alternative, meanwhile, is that the demand for manufactured goods and other exports becomes more stable: this, in turn, would lead to the dollar being comparatively stable against its trading partners.

So which is the best option for the economy? The answer, according to the professors, depends on which sector can best adjust to large fluctuations. In this regard, the commodity sector appears to be in the best position because after a period of shutdowns it is comparatively easy to restart production when prices rise again. However, the reality of starting up, they state, is often very difficult – much more complex than starting oil production. As such, fluctuations with the Canadian dollar are becoming even greater. With producers seeing that the dollar is a commodity currency they are looking for the dollar to be weaker and weaker before they return their production to the country. Consequently, they believe there is a case to be made that the economy would be better off if the commodity sector were to absorb more of the fluctuation in prices and make the non-commodity sectors more stable.

With this in mind, the professors conclude that while an exchange rate targeted system is open for debate and risky, the current inflation targeting approach is also not the best option and it’s time for the Bank of Canada to reconsider its framework.

What are your opinions on this subject? How do you react to the professors’ claims? Leave a comment below with your thoughts.